High-Energy Income

What investor wouldn't want a 6% yield and a stake in America's energy boom? One single investment -- the master limited partnership -- can provide both. But it's not an easy corner of the market to negotiate. Our Roundtable participants show you how.

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What investor wouldn't want a 6% yield and a stake in America's energy boom? One single investment -- the master limited partnership -- can provide both. But it's not an easy corner of the market to negotiate.

MLPs flourished after 1987, when Congress changed the tax code to encourage investing in energy infrastructure, especially the pipelines used to transport oil and gas. That encouragement came in the form of a corporate tax break: MLPs avoid corporate taxation since they must pass most of their cash flow to investors. The structure also allows for some pretty advantageous tax treatment at the investor level. This scenario has helped the industry's slow-but-steady growth to more than 80 energy MLPs today.

Let the Income Flow

MLP performance has been impressive, though it's lagged to this point in 2012. The benchmark Alerian MLP Index, which tracks the 50 largest MLPs by market capitalization, has returned 5.9% so far this year, but has a total return of 90% over the past five years, trumping the 10-year Treasury and the Standard & Poor's 500.

Will this boom continue? We gathered three private wealth advisors with dedicated MLP investing strategies to weigh in. Their answer: Yes.

J. Michael Bollinger, 40, is with Morgan Stanley in Houston, where many of his clients have strong ties to the energy trade. He manages $300 million in MLP assets.

R. Christopher Errico, 44, at UBS in New York, has a third of his investments in individual MLPs.

Gary L. Ran, 54, is an independent advisor and chairman of Telemus Capital Partners in Southfield, Mich. Ran makes use of MLP funds.

Despite the enthusiasm around MLPs, there's a lot for investors to understand. Even the vocabulary can be challenging. For starters, shares are called units. The payouts, driven by the MLP's earnings, are distributions, though the distribution is often referred to as a yield. Just don't confuse that with a dividend: Most of an MLP's payout is taxed as a return on capital -- which comes with important adjustments and no small amount of confusion. (The taxation of MLPs is such a gnarly topic we've tackled it in a sidebar, "When Big Payouts Mean Big Headaches," see bottom of story.) And then there's the energy industry, which is impenetrable for many investors. Our trio of experts attempted to simplify the ins and outs of this alluring-but-complicated investment.

Barron's:Let's start with the basics. Why do you like MLPs? Is it just that they're paying, on average, a 6% distribution, or is there more to it?

Bollinger: We are still in the very early stages of the MLP's evolution. The industry could easily get to $500 billion in market capitalization in 10 years, from about $300 billion today. MLPs have a great total return, a combination of yield and growth, which is difficult to find anywhere else.

Ran: In the early 1990s, income investors had Treasury yields of 4%, 5%, and MLPs were an unknown asset class. As interest rates go higher, some MLPs won't be able to keep up. That's why we are a little cautious about adding money here. But we still like MLPs.

Errico: Whenever you can buy a business that pays you more this year than it did last year, especially in a low-interest-rate environment, that is a good place to be. And their businesses are sound. You have to transport this new U.S. oil and gas. We're seeing the largest energy infrastructure buildout since World War II, and it's creating a lot of jobs.

So why aren't more people invested in MLPs?

Bollinger: A lot of MLPs aren't investment-grade. Many are small-caps. Well gosh, that sounds like a volatile investment.

You mention an investment-grade rating. Are MLPs rated as bond-issuers are?

Bollinger: MLPs typically borrow money or issue equity to fund their growth. Because they are required to pass through the majority of their free cash flow as distributions to unit holders, they need to issue debt to finance new projects. But they have the cash flow to cover borrowing costs. If you don't understand how they are structured, MLPs can appear more risky because they are more levered.

Errico: In October 2008, I worried the world was coming to an end. We were very close to having no credit. But MLPs bounced back big time in 2009 because credit loosened up. Some increased distributions, while banks slashed them.

Please explain the distinction between an MLP distribution and its yield.

Errico: If you own a $10 MLP and it pays a $1 distribution, that's a 10% yield. If that MLP price goes to $20, that yield would be 5%. Your distribution is still $1. But because MLPs can grow by making acquisitions, raising money, and building new things, their cash flows expand, they must pay out most of that cash flow, and they raise their distributions. The key to this whole sector is owning the MLPs that raise that distribution over time. Then your stock price increases.

And the yield?

Errico: If the stock price goes up, the yield might go down. But if the distribution is going higher, you benefit because the MLP price goes higher.

Interest rates are at historic lows. When interest rates rise, what happens to MLPs?

Errico: MLPs are definitely more attractive in low-interest-rate environments. If rates go higher, MLP investors may have more opportunities for lower-risk investments with higher yields, like municipal and high-grade bonds. But the fact that MLPs can increase their distribution provides a cushion for investors. Some pipelines are talking about raising their distributions in the next three years regardless of where interest rates go.

Bollinger: If interest rates go up slowly, that's OK for MLPs. If rates go up precipitously -- one or two percentage points in a short time frame -- it will push yields up and prices down on MLPs. Right now, there is roughly a 450-basis-point spread between the average yield for the Alerian MLP Index and the 10-year Treasury. [One basis point is 0.01%.] Since 1998, the average spread of the Alerian and the 10-year is 340 basis points. MLPs are trading at a roughly 100-point discount to their historic average. The space will be influenced by interest rates, commodity prices, and other market factors. But MLPs' ability to raise their distribution consistently by 5% to 10%, on average, can overcome those hurdles, given enough time.

How do commodity prices affect MLPs?

Errico: Pipelines typically collect steady fees with long-term contracts, regardless of the commodities that pass through the pipe. Other MLP businesses that find and process natural gas, oil, or other products, though, may get lower prices for their goods; cash flow then decreases and therefore distributions may decrease.

The original MLPs were pipeline businesses. The biggest MLPs are still these "midstream" operations, but the field is expanding "upstream" and "downstream" as well. What does all that mean?

Bollinger: The traditional midstream MLP assets you refer to include the intrastate pipeline systems that take products to storage, regulated interstate pipelines that go across state borders, and the gathering and processing systems that take natural resources from the wellhead to the distribution point. Upstream is exploration and production. E&P MLPs are still relatively new. They find long-lived oil and gas assets after they have had a drop in production. But these assets have a long tail, which means future production will have a slow decline, and still provide steady cash flow.
Linn Energy
[ticker: LINE] was among the first new E&P companies to go public as an MLP, and now there are a handful.

Errico: A business in the midstream is a toll collector that takes products from point Point A to Point B. They have monopolistic characteristics. Planes wouldn't fly, homes wouldn't be heated, and businesses couldn't run without these entities. Our biggest position, the one I've got the most confidence in right now, is
Kinder Morgan KMI -0.06320754716981132%Kinder Morgan Inc.U.S.: NYSEUSD21.1866
-0.0134-0.06320754716981132%
/Date(1481301580219-0600)/
Volume (Delayed 15m)
:
1863023
P/E Ratio
N/AMarket Cap
47326118793.0023
Dividend Yield
2.3623907394283012% Rev. per Employee
1167320More quote details and news »KMIinYour ValueYour ChangeShort position
[KMI]. It's the general partnership that owns
Kinder Morgan Energy Partners
[KMP], one of the largest U.S oil and gas pipeline companies. About 95% of its revenues are fee-based. What distinguishes KMI, and any MLP general partner, is that it gets a higher percentage of income when KMP raises its distribution, much like a general partner in a hedge fund or a real-estate partnership.

People call CEO Richard Kinder an MLP pioneer.

Errico: Rich Kinder left Enron in 1996 and purchased Enron's pipelines. I've owned KMP since 1997. After 15 years of listening to him on conference calls, I can say he under-promises and over-delivers. He pays himself $1 a year.

And the shares?

Errico: KMP has had a 25% annual return since 1996. Kinder just did a legendary, transformational merger, buying the general partnership of
El Paso
[EP]. Kinder Morgan now owns two pipelines and two general partnerships. KMI could double its distribution in the next five years. Today, you get $1.40 in distributions, or 4%, and it is a $35 stock. If you get $2.50 in distributions, that's a $62 stock. KMI, the general partnership, is where Rich Kinder has all his money. He made my career in the 1990s. I'm not worried about whether he is going to cover the distribution.

Gary Ran prefers to invest in MLPs through closed-end and other types of funds.
Gary Spector for Barron's

Bollinger: We initiated a position in KMI after the El Paso announcement in October.

Mike, what do you look for other than valuation?

Bollinger: We don't want everything concentrated on the Gulf Coast of Louisiana and a hurricane comes in. We don't want everything exposed to the price of natural gas or natural-gas liquids. We want crude oil, we want refined products. We want the big companies as well as the small- and mid-caps names that could become large-caps.

Valuing MLPs is very different from valuing stocks. One metric often used is an MLP's coverage ratio, which is the MLP's distributable cash flow divided by how much it actually distributes. What exactly does that tell you?

Errico: How much cash flow an MLP has after it pays the distribution. It tells you if the MLP has extra cash. If MLPs are healthy, they generally cover their distribution by 1.1 or 1.2 times.

Ran: You still have to buy good businesses, not a micro-cap with a risky business model.

What MLPs do you like now?

Bollinger: I see value in stories like
Copano Energy
[CPNO], where everything hasn't gone exactly to plan but the long-term story is good. A large part of their business is a natural-gas pipeline and gathering system in the Eagle Ford Shale in Texas. They also process natural-gas liquids.

What do you think about all the new MLP funds and exchange-traded products?

Bollinger: Funds help the liquidity and overall sustainability of MLPs as an asset class. Fund investing also makes the tax aspect simpler. When you invest directly, you get a K-1 limited partner tax statement for every MLP you own. Funds pay corporate-level taxes and send investors a single 1099 tax form for the entire portfolio. But I wonder how many fund investors fully understand the haircut, the [index] tracking error they get in exchange for tax simplicity.

Gary, why MLP funds?

Ran: My clients have a lot of their money tied up in retirement plans, where direct MLP investment doesn't work. There is unrelated business taxable income, which is not deductible, and ends up being a penalty in a retirement plan. My advice to the small investor: You might be doing yourself a disservice by investing directly, because the cost of your accountant might be more than the benefit.

There are more than a dozen closed-end MLP funds. [These funds have a fixed number of shares that "go public" much like a company. They can trade at a discount or premium to the value of the underlying assets.] How do you value a closed-end fund?

Ran: You never want to buy a closed-end fund at an initial public offering. You want to buy it shortly thereafter, when it starts trading at a discount to its net asset value. We like the closed-end fund structure because of the leverage employed.

That leverage, or borrowing, can enhance returns -- but it can also magnify losses.

Ran: There is more volatility in a leveraged closed-end fund. The
Cushing MLP Total Return FundSRV 0.3854362935570375%Cushing MLP Total Return FundU.S.: NYSE12.84
0.04930.3854362935570375%
/Date(1481301391272-0600)/
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:
12534
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N/AMarket Cap
N/A
Dividend Yield
8.40466926070039% Rev. per Employee
N/AMore quote details and news »SRVinYour ValueYour ChangeShort position
[SRV], for instance, carries a big loss from the financial crisis. But there's also a tax advantage there, as that loss offsets any gains. That deferred asset, the loss, is a hidden gem on their balance sheet. As a result, the fund trades at a premium. We have bought SRV at both discounts and premiums. We also own the
Kayne Anderson MLP Investment Fund KYN 0.6251303441084463%Kayne Anderson MLP Investment Co.U.S.: NYSE19.2999
0.11990.6251303441084463%
/Date(1481301486327-0600)/
Volume (Delayed 15m)
:
55739
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N/AMarket Cap
N/A
Dividend Yield
11.413689163739747% Rev. per Employee
N/AMore quote details and news »KYNinYour ValueYour ChangeShort position
[KYN] and the
JPMorgan Alerian MLP Index ETN
[AMJ], which just stopped issuing shares, so now it is, in essence, a closed-end fund. But you have to be cautious about buying AMJ, and not buy it at a premium. And because an exchange-traded note is a debt instrument, there's also credit risk.

Thanks.

When Big Payouts Mean Big Headaches

Correction:A previous version of this sidebar incorrectly stated the tax treatment of the distribution when an MLP's cost basis reaches zero. It is generally taxed as capital gains.

Calculating the tax on a master limited partnership (MLP) isn't for the faint-hearted or math-averse. But even if you plan to use an accountant, you need to understand the basics before you buy. MLPs are generally taxed more favorably than stocks and other securities, but if you don't understand how they work, you can end up with a nasty tax surprise.

When you buy an MLP, you become a limited partner in a business. The business itself doesn't pay any tax, since it passes virtually everything -- profits, losses, depreciation, among other items -- to the unit holders. You'll receive a portion of the MLP's net income, as well as quarterly cash distributions.

You'll often hear that about 80% of the MLP's distribution is tax-deferred. What that actually means is that your share of the MLP's annual net income equals just 20% of the cash distribution, according to the trade group National Association of Publicly Traded Partnerships. This distinction is important. You'll pay ordinary income tax annually on any net income.

Unlike stocks, your cost basis in the MLP isn't simply what you paid for it; it's adjusted both up and down. Your share of the MLP's net income increases your basis. (Think of it as reinvesting stock dividends.) Your distributions are considered a return of capital, which reduces your cost basis. It's complicated, but it makes sense: Your cost basis is essentially the capital you put up to join the business. If the partnership returns some of that capital, your basis is reduced. You won't pay tax annually on this part of your payout, but there are big implications when you sell the MLP or the distributions lower your basis to zero. More on that in a minute.

Let's say you buy an MLP for $30. In that first year, your share of the MLP's net income is $2. That raises your basis to $32. Let's say you also received cash distributions of $2.50, and $1.50 in depreciation, each of which lowers your cost basis -- so now it's $28 ($32 - $4=$28). If you sell the MLP next year for $30, you may think you won't owe any tax since there seems to be no gain -- after all, you only paid $30 when you bought the MLP. But since your basis has been lowered to $28, you actually have a gain of $2 per unit.

Now, here's where things get interesting. There's billions of dollars earmarked for energy infrastructure projects, which will help MLP distributions increase. But as distributions rise, your cost basis could be whittled to zero. Once that happens, any distributions are generally taxed as capital gains.

What's more, the biggest MLPs are pipeline businesses, many of which transport oil, gas and natural gas across state lines. That means you could have tax liabilities in multiple states, regardless of where you live.

If the Bush-era tax cuts expire in January 2013, MLPs may become even more attractive, because stock dividends will no longer be taxed at the low 15% rate. Instead, they'll be taxed as ordinary income at rates as high as 39.6%. The net income portion of MLP payouts, meanwhile, is already taxed at ordinary income tax rates, the highest of which is now 35%, so any hike may not be as jarring. But more importantly, the vast majority of an MLP payout is tax-deferred, and not an issue until you sell or your basis goes to zero.

"If tax rates go up, then the value of the MLP tax deferral is magnified," says Robert Willens, a New York CPA, and former KPMG tax partner and former star tax analyst at Lehman Brothers. He owns a few MLPs himself.

If you're still completely baffled, rest assured that many accountants find the tax headache wearisome as well. Some, says Gary Ran, a Michigan independent advisor, act like a "Svengali" over clients and dissuade them from owning individual MLPs. One reason Ran himself prefers exchange-traded products is their tax simplicity. Also, smaller investors be warned: Ran says the cost of your accountant can mitigate or erase the tax benefit of owning an individual MLP.